1 The Asian Banker Summit 2004 Capital Management After Basel II Simon Topping Executive Director (Banking Policy) Hong Kong Monetary Authority 5 May 2004

2 Basel II Influence on Capital Management (1) Ideally, under Pillar 2, all banks would have an internal capital adequacy assessment process (CAAP) – i.e. a process for assessing how much capital is needed to support the risks they undertake – and this would determine their target capital ratio  Ultimate goal : Economic Capital = Regulatory Capital Only the largest banks currently use economic capital models, but Basel II will provide the impetus for smaller banks to develop such models A gradual evolution of capital management practices among banks is envisaged

3 Other aspects of Basel II will also encourage development of banks’ capital planning and risk management strategies: –Availability of more sophisticated approaches to measuring credit risk, i.e. Foundation and Advanced Internal Ratings-based (IRB) Approaches –Greater use of stress-testing for assessing capital impact arising from business cycles and adverse events –More focus on non-credit risks in determining capital Basel II Influence on Capital Management (2)

4 More Comprehensive Recognition of Risk (1) Fundamental to effective capital management is a bank’s ability to identify, measure and control all significant risks that affect its internal capital assessment Under Basel II, focus is not just on credit risk – banks need to look to improving their risk management and determination of capital requirements in other areas: –Operational risk and market risk under Pillar 1 –Other non-credit risks (e.g. interest rate risk, “residual” operational risk, liquidity risk, litigation and legal risk, strategic risk and business cycle risk etc.) under Pillar 2

5 More Comprehensive Recognition of Risk (2) This will encourage banks to put in place a comprehensive process for identifying and measuring both credit and non-credit risks in their business and making a more precise allocation of capital against such risks

6 Greater Diversity of Approaches to Credit Risk Basel II provides for the following approaches to measuring capital charge for credit risk : –Standardised Approach –Foundation IRB Approach (banks estimate PD) –Advanced IRB Approach (banks estimate PD and LGD) For banks adopting IRB, estimation of PD and LGD of credit exposures will enable them to allocate capital against individual exposures (or groups of exposures) in a more systematic and precise manner Credit risk stress-testing will also play an important role in internal capital assessment (a specific requirement under IRB)

7 Capital Charge for Operational Risk (1) Addressing non-credit risks – in particular, operational risk – may be of a higher priority than refining credit risk management for some banks A specific capital charge for operational risk is required under Basel II – its impact on banks could be quite significant. (Some international banks allocated around 12-18% of capital to operational risk)

8 Capital Charge for Operational Risk (2) In Hong Kong, our focus is initially on implementation of the Basel sound practices for operational risk management rather than advanced measurement approaches (which are still at a very preliminary development stage) Majority of banks in Hong Kong is expected to adopt the simpler approaches, i.e. Basic Indicator or Standardised by end-2006, although development of data systems capable of being used for AMA (Advanced Measurement Approaches) purposes will be encouraged in due course

9 Development of CAAP To implement Pillar 2, banks will have to demonstrate to their regulators how they conduct economic capital allocation In practice, while banks will develop their own capital models and will be actually using such models internally, the regulator will, at least initially, conduct its own assessment and set the minimum capital ratio (although the results of a bank’s CAAP will also be taken into account) As a matter of principle, the more effective is a bank’s CAAP, the more it will be possible for regulators to rely on this for setting the minimum capital ratio (and forming a view on the appropriate buffer above the 8% minimum) over time

10 Better Capital Allocation Against Risks More precise allocation of capital against risks should help banks to: –make more efficient use of capital –develop appropriate business strategies –develop more sophisticated risk-adjusted pricing (i.e. measuring return on capital) –employ hedging strategies through credit derivatives and insurance

11 Maintenance of Capital Levels Currently, many Hong Kong banks hold capital well in excess of their regulatory minimum. This suggests that factors other than regulatory requirements are at play (e.g. market expectations) However, in principle, the coverage of a greater range of risks under the Pillar 1 and Pillar 2 capital requirements may enable banks to reduce the size of this “buffer” In the case of banks which currently have very high capital ratios, there may be scope to reduce the level of capital maintained Generally speaking, however, we do not expect to see much immediate change in overall capital levels upon implementation of Basel II

12 Concluding remarks (1) By emphasising the importance of risk management and risk-sensitive capital requirements, Basel II provides banks with the incentive to improve risk management and internal capital allocation Basel II also paves the way for banks to develop CAAP and make more use of economic capital models. However, regulators are expected to continue to set minimum capital ratios for banks, as the process of converging economic capital with regulatory capital will take time

13 Concluding remarks (2) More efficient capital management, as well as better understanding and management of risk, should enhance the risk-adjusted return of banks Nevertheless, individual banks will need to carefully assess the associated costs and benefits and prioritise their plans to upgrade capital and/or risk management practices